Buy to Build

To explore how private equity firms identify, choose and nurture portfolio companies that can grow through bolt-on acquisitions to lead an industry, Mergers & Acquisitions convened a special roundtable discussion, sponsored by Benesch, a business law firm prominent in middle-market dealmaking. The discussion provides a range of perspectives on the strategy. Participants include two private equity investors, one portfolio company chief executive, an investment banker and an attorney.

James Hill, Benesch (pictured): I think it is an important strategy because today in our economy, companies are not growing organically quickly. So if you are buying a company and really hoping to get a high internal rate of return on the basis of organic growth, that alone will probably not get you there, unless you are a highly technologically-driven company with a lot of proprietary technology that you are developing constantly.

A far better approach that a number of private equity firms have adopted is finding an industry that they have some expertise in and buying a platform company that meets both the infrastructure needs and the product differentiation needs to give them a leg up on the channel to buy additional companies in that industry. It's very important to grow both organically and acquisitively. But, ultimately, when you are selling your company, or you are recapitalizing your company, it's very important to be able to explain to a buyer that you have done some significant operational improvements in your company to grow both organically and acquisitively. That makes it a more attractive target for someone who's looking to buy his or her next company.

Russell Greenberg, Altus Capital Partners (pictured): In my opinion, the buy and build strategy works if you have a management team that can execute it. We look for people that have a bigger vision, that have had experience running larger companies, that think strategically about where the business should be in five years, not just how to make the current-year numbers. They are thinking product-wise. They are thinking strategy and the tactics to do it.

Timothy Nelson, Saw Mill Capital LLC (pictured): We encourage our companies to think out 10 years, asking them, "How do you position your company to be ready to double in size for the next investor?"

Hill: One thing Benesch has done successfully over the years is find great CEOs who have been very successful in an industry. One of the metrics we have to check off fairly quickly is their acquisition experience and their ability to integrate those companies. There are a lot of successful CEOs who have grown companies but who don't have acquisition experience. The CEO really needs to have gone through that process several times and be able to point to some success at integration, or you are kind of starting out behind the eight ball. There's probably an exception when people are running large divisions or subsidiaries of larger companies, when they may not have had the opportunity to make acquisitions.

Greenberg: We've had success with a CEO who hadn't done add-on acquisitions but was a strong CEO from the strategy point of view. Our firm laid out strict guidelines; we had the right planning; the chief financial officer was very on top of everything; and it worked out okay.

Nelson: We had a similar situation with our former portfolio company, Pexco LLC. It was a corporate carve-out, and so that was a manager who didn't have acquisition experience prior, but his entire career was with the parent company, Filtrona plc. What made him strong was that he was very disciplined. He was process-oriented, really focused on the operations of the business, and he drove the disciplines in the organization. When you're executing an acquisition program, that's critical. The easy part, I would say, is buying. The hard part is integration, post-close. It's fundamentally critical to have those operational practices and disciplines in place to integrate the companies. You need to have the strong discipline culture when you are acquiring those entities.

Flynn: Ted, before becoming CEO of Royal Adhesives, did you have acquisition experience?

Ted Clark, Royal Adhesives & Sealants LLC (pictured): I did. I worked for a public company, PRC DeSoto International, Inc. which was the global leader in aerospace sealants and coatings, that later got bought by a much larger public company, PPG Industries Inc. (NYSE: PPG). But my role was running one of the big divisions, and in that division, we had a very strong M&A approach to building the company globally, and I executed on that strategy.

That's what got me into the private equity sphere. When the company was being sold, I got some private equity backing to buy PRC, but we were out-bid by PPG by $100 million. That was my first lesson in private equity. But we ended up looking at the entire adhesives and sealants market, and I think one of the big things that's a predictor of potential success is looking at the size of the market and how fragmented it is. Are there enough targets out there that, statistically, you can feel comfortable pursuing an aggressive growth strategy without getting cut off at the pass at one place or another?

In my case, we thought it was a great idea. And we put together a pitch book and started talking to private equity groups. Middle-market private equity people are always looking for ideas on how to grow, and I had the experience and the contacts, and they had the equity. But what we needed together was the commitment, because it is not an easy road by any stretch. You never get the first company that is exactly like you envisioned it would be. But if it has three or four of the five or six characteristics you are looking for, it is a good thing to move forward on and get started. And then the other thing is, particularly with the private equity partner, are they committed to doing all the work that they would do on smaller deals and larger deals? Because you are going to get a mix of both to build the company, and you have to be committed.

I have been fortunate that the private equity people that I have worked with for the last nine years on building Royal have been very committed to doing both small and large deals. We made a good choice with Quad-C Management Inc., our first private equity partner. In 2010, the company was sold, and Arsenal Capital Partners bought it, and they had a very strong specialty chemical practice within Arsenal.

Mark Brady, William Blair & Co. LLC (pictured): There are many occasions when there's an entrepreneur who sees the opportunity and knows what the right businesses to buy are, but the fact of the matter is, he started the business himself. All of the capital is his, and if he goes out and makes a major acquisition, it is in many ways a significant dice roll for that entrepreneur. But once he goes through a private equity transaction, gets some capital off the table, brings some new capital into the business, brings some expertise with respect to being able to identify and consummate acquisitions, and maybe a little more professionalization of the management team, and people who actually know how to integrate these acquisitions, then he is able to go out and effect these deals.

TMW Systems Inc. is a good example. It was founded by Tom Weisz in 1983 as a software company that was servicing the small-trucking business, and he built it up to become a very important provider of transportation-management software for trucking companies. It was bought in the mid-2000s by what was then Wachovia and is now called Pamlico Capital, and Jim and I worked together on the transaction. Tom had identified these five businesses that TMW should buy, which was to add geographic presence in Canada, to add technological capabilities, different customer bases, retail providers, logistics and transportation brokers, a dedicated fleet and then to add technologies. Because Pamlico had put fresh capital in, they were able to go out and do those deals and integrate the businesses so they were all on one profit and loss statement. Recently, we helped with the sale of TMW to Trimble Navigation Ltd. (Nasdaq: TRMB) for $335 million, and Pamlico made 11 times their money.

Flynn: What role does private equity play, beyond writing the check?

Greenberg: A lot of times, I think our role is to say "no" to the management. Some of our companies bring us things, or we bring them things, and once we vet them and do due diligence, we find out, no, that is not accretive to shareholder value, or it is not accretive in a time period that would be right for us, in terms of an exit. In addition to writing the check, private equity needs to vet the potential acquisition, or the portfolio company is just gaining size and not gaining shareholder value. We bring a level of extreme discipline.

Clark: In my case, both private equity firms worked for me. We had small boards that included one or two of the private equity partners, and they were instrumental in helping us stay on track. There's a tremendous amount of financing work and all kinds of stuff that has to go on behind the scenes to get these deals done. I couldn't have done what I wanted to do without that private equity support, which goes well beyond just writing a check and having a relationship with the lenders.

Nelson: We view our role as making sure our managers have all the resources they need to grow their companies. We're dealing with lower middle-market companies, companies that are in the range of $50 million to $150 million. Operational practices, such as the information technology (IT) infrastructure, are fundamental, and they require outside resources to develop, such as consultants to help train the employees. The stronger the platform can get, the more acquisitions you can do. You can do three acquisitions in one year. Pexco did four acquisitions in one year itself. And if it didn't have the manufacturing practices and disciplines and the deep training, it wouldn't have had people to deploy during those acquisitions to integrate the back office, to transition their manufacturing practices to the Pexco processes. The stronger that process is, the more sustainable, and the more achievable long-term growth is.

Hill: One company we worked with did 12 acquisitions in three years. You have to have a deep team on the corporate side. You have to have a deep team on the financial side. You have to have a deep infrastructure within the company itself. I have been doing this for over 30 years, and I think one of the things that private equity firms are fundamentally helpful with is helping you as a CEO build your infrastructure.

The right-hand person for every CEO is the CFO. And oftentimes when we make the first acquisition for a private equity firm, the CFOs are not incompetent, but they are not strategic either. They are not thinking about the bigger picture five years from now. They might not have to leave the company. You can make them a controller. But the private equity firm can add a lot of value in those areas.

Brady: To think about it from the standpoint of the entrepreneur, he spent his whole life building one business, and the private equity partners have seen many different operations. So the private equity firm tells the CEO to make acquisitions. The CEO may be thinking, "Where do I even go to find them?" The private equity firm says, "We're going to put six companies on one infrastructure. We are going to close two plants." And the CEO is thinking, "Well, how does that work? I have absolutely no idea." The PE firm says, "We're going to consolidate supply, and we are going to reduce our purchasing costs." The CEO thinks, "I haven't been through that exercise myself." Well, the private equity players have. They say, "We are going to do things like advertise on a national basis; we are going to negotiate bulk purchasing; we are going to use a global sales force." It's things that the private equity operators have seen before that this entrepreneur, who may be an absolute genius in his particular specialty, had no reason to encounter.

Flynn: What about tensions between private equity firms and portfolio CEOs?

Greenberg: It's a collaborative process, and there has to be give and take. And sometimes it doesn't work out. When the CEO and the private equity firm just want to go in different directions, that can lead to stress, and that can lead to departures, too. At the end of the day, the private equity owner is the majority owner, and there can be situations in which the CEO isn't right for that buy and build strategy or for executing what the private equity firm wants, and then you have to replace him. That's pretty much why the private equity firm runs the board, to be able to replace and bring in somebody who has a more shared vision. We have been through one of those a number of years ago, and it is not fun, but you have to do it to move the business forward.

Nelson: When that happens, it definitely sets you back a year or two, especially if you are replacing at the CEO level. Time is our enemy. We are talking about an investment horizon that's four to six years, and that is not a long time.

Clark: You can get a good manager to do operating cost stuff, but the growth stuff is key, and the growth stuff also takes the most trust between the private equity and the CEO. Getting the right sort of partnership, or the right shared vision, is key to growth. You are always going to have setbacks. We went through 2008, as everybody did, when our sales suddenly went down 30 percent. So you have to have a partner that's going to stay with you and ride through it. And you have to have a smart private equity group that hasn't kind of overleveraged the business in the first place, so that you can get through that period financially with the cash flow that's generating on 30 percent less sales for, say, 18 months or whatever that period was. The more I have been involved with it, the more I really respect the private equity investors and how they operate. As an entrepreneur, or somebody who wants to build a business, private equity is the fuel that builds businesses. There are very few that I have ever run into, or that I've worked with, who have just said, "Well, let's close three plants, and then we will sell the business." There are very few that have really looked at it as just financial engineering.

Flynn: What role does the investment bank play?

Brady: If you think about it from the standpoint of the entrepreneur who is going through an auction, he might meet 15 private equity firms over the course of about four weeks, and he's got dinners every night. At some point, it just all starts to look the same. In the deal we just did a few weeks ago, the CEO pulled me aside on Thursday morning and said, "We have had steak and red wine for the last three nights. If you take me out for steak and red wine again, we are going to fire you." My assistant lined up a Latin American restaurant. And we went over to the Latin American place, and it was absolutely a blast. And I will tell you, that bidder ended up buying the company. They went from $280 million to $345 million. That must have been a great dinner!

If you think about yourself as the CEO in that circumstance, how does he know? He has to rely on his adviser to have information on the private equity firms and how they behave and what their history is. We keep all that information so that we know how they are to work with and how they do things, and it can be helpful. But, boy, if it is difficult for the PE firm, it is tough for the CEOs, too.

Hill: I started practicing law in 1979, and the market has become so much more efficient over the last 30 or so years. People who are trying to buy companies are challenged by the fact that even a $35 million company with a 12 percent Ebitda is now being auctioned. Now, that's a good thing for the investment banks, and they do a great job at it. They maximize value. But it's a very different business than it was even 25 years ago, and more challenging. You need to bring more talent to the table. You need to bring more operational skill to the table. And you need to bring more industry focus to the table.